Spark for the next Lehman style crisis is likely to come from Europe

Tue, 11/09/2018 - 09:59

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On the 10-year anniversary of the Lehman Brothers collapse, Jens Hagendorff, Professor of Finance at the University of Edinburgh Business School, explains why low levels of bank capital mean the financial system is still vulnerable…

The Lehman bankruptcy almost sent the global financial system into meltdown and 10 years on, it remains vulnerable. Increasing bond spreads in Italy, jitters in emerging markets, and the low market valuations of European banks show today’s investors are nervous.

Equity capital is the most effective absorber of bank losses. Since the Lehman collapse and the crisis that followed, many banks have increased their equity capital. However, the discussion far too often focuses on increases in capital. The problem with this is that even sizeable increases in equity are not sufficient if the level of equity pre-crisis was painfully low.

Today, the level of equity held by many of Europe’s largest banks remains low. The spark for the next Lehman style crisis is likely to come from Europe. In Italy in particular, the doom loop between banks and their government continues. Italian banks are major buyers of Italian government bonds. Even a small haircut on those bonds (not an improbable scenario given recent spikes in spreads or the increasing price of insurance against such an event) would cause Italian banks such as Unicredit to become insolvent. What would follow will enter the history books like the Lehman bankruptcy.

The goal is not to design a banking system in which banks do not fail -that would never be possible. Banks have failed since the area of the Medicis in Renaissance Florence. The goal is to design a financial system in which banks may fail without endangering the stability of the global financial system. The Lehman bankruptcy has taught us how not to fail a bank. Global regulators are still working on the rest.